The Beginner’s Guide to Money!

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Written by PolicyBazaar

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Modified 04 July 2016

Money is the one of the most important elements in our life. After all, it makes the whole world go round. Everyone talks about it all the time, be it the public or the politicians. Everyone wants to be a billionaire, fast and easy. But the bitter fact is, there's no secret recipe for making money. The first step to make money is to understand what it is. The money has become such an obvious thing in our lives that we have forgotten, what it is essentially. So here's a fool's guide that takes you back to the basics of money and tries to give simple answers to not-so-simple questions.

What is money after all?

Money can be defined in many ways.

It is a medium of exchange that was introduced to simplify the complex barter system.

It is a certificate of the common perceived value of a thing.

It is an instrument of standardizing and storing value for a good or service.

Why do people prefer depositing their money in banks instead of locking it in treasure chests or hiding it under a mattress?

The reasons are numerous. Starting with the most obvious, depositing it in the bank rather than keeping it at home reduces the risks of it being stolen. Further, depositing it in the bank lets you earn an interest on it. Plus, you get to carry the money in the form of cards and cheques instead of having to carry the actual heavy cash. Anyway, the money isn't supposed to stay in lockers as it works best when moving around.

Why doesn't a country print lots and lots of money and make everybody rich?

Gold has a high value, not because it shines but because it is a rare commodity. Currency is no different. The thumb rule to every asset is, the more available it is, the less valuable it becomes.

If a country decides to print lots and lots of paper money, it'll lead to a currency devaluation. Here's why, when the amount of currency increases, the value of goods and services spreads out (thins out) according to the increased currency thus making every unit more costly.

Put simply, an increased supply of currency without any increase in the supply of good and services will end up raising the cost of goods, thereby disbalancing the economy. To get an understanding, suppose there are 100 bananas in the market and 100 rupees is the total amount of currency. Thus, a person gets 1 banana for 1 rupee (Rs 100/ 100 bananas). Suppose out of charity, the government decides to print additional 50 rupees and distribute it among public. Now, the total currency is 150 rupees while the bananas are still 100 in number. A person now will have to pay 1.5 rupees for buying 1 banana (Rs 150/100 bananas).

As can be seen from the above example, the more currency the government prints, the less affordable commodities are going to become. There has been quite a few incidents in the past as a testimony to this fact. Germany decided to print more currency between the year 1921-24 to get over the after effects of world war I. The implications were shattering. At that time, the value of German mark fell so drastically that '1 American dollar = 4,210,500,000,000 German marks'.

To summarize, if everyone has more money, it'll end up making everything more costly. And we'll not be better off than before, as a matter of fact, we'll find ourselves in a much worse situation.

What is Inflation?

Inflation is when the value of a currency falls over time. The higher the rate of inflation, the lower will be the purchasing power. Inflation is the culprit that brings down the value of your hard earned savings by decreasing the present monetary value of your savings. The law of supply and demand is the simple underlying mechanism behind inflation. As the population is on rise, the demand for goods or services is on rise as a result of which they getting more valuable and costlier with time. So you need more bucks to buy the same product after a span of time.

Consider this, the rise in prices leads the workforce to ask for higher wages, the higher wages in return leads again to rise in prices. Thus, inflation is a fire that keeps fueling itself.

How to Combat Inflation?

The best way to counteract inflation is to make a timely investment in an asset that assures a higher rate of return than the rate of inflation. Suppose you have 1000 rupees today and the present inflation rate is 7%. If you want to neutralize or win over inflation, you'll have to make an investment that yields a rate of return not less than 7%.

How do Banks Create Money?

Banks create money by lending the money to borrowers and earning the interest. The money a bank lends come from the pool of money made out of the individual deposits in a bank. A portion from this pool is kept in the reserves (about 10%) and the rest is lent out (90%).

Can Money Buy Happiness?

No, it cannot! Money is often confused with wealth but the truth is that it's not the real wealth. The real wealth or the real value is in goods and services and not in the money. Money in itself is a valueless thing. If you find it hard to digest, imagine yourself marooned on an island with a treasure box but nothing to eat or no clothe to wrap around. In such a case, all the treasure you have will be as worthless as pebbles.

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